Wednesday, November 19, 2008

Never Try To Catch A "Falling Knife"

As many investors (Warren Buffet included) have been attempting to pick a bottom in this bear market over the last few months they are learning that this is a poor risk/reward proposition.

Mainstream and traditional investors have a great fear of missing a bottom in the stock market. This (among other things) creates bear market rallies that smart traders and investors use to get short on the dominant bear trend. In my view, an investor or trader should exploit the actions of traditional investors, who usually wind up as victims of our inherently flawed economic/political system.

Its good to have a healthy dose of contrarianism in the mental framework that guides your decisionmaking, but it must be done in the right context.... Thus, I offer some advice:

Maximize caution at market turning points - Just because stocks are cheap and have fallen a great deal does not mean they can't fall farther and get cheaper. Price action must always be your guide. Weak market should be sold, stong markets should be bought.

Align tactics to strategy and expections - If you buy something because you feel it is cheap, it may take a long time for the value to be realized. Warren Buffet can hold onto something for 10 or 20 years, and oftentimes never sells... are you prepared to do the same? If you buy something just because it has fallen 80% in price and you feel it is a good "value" do not be surprised if it falls another 50% from where it currently is - if you expected the price to rise short term you may wind up very disappointed. THis is usually what happens with companies that are not true "value" plays.

Minimize contrarianism at at support, resistance, and market extremes -Are you contemplating taking a contrarian position just because market prices are at some support or resistance level or some extreme price level. This is contrarianism just for the sake of contrarianism. Is there any real justification for being contrarian - are there any fundamental reasons outside of prices being low that would make you want to own stocks - the economy continues to fall apart and so are earnings so why be contrarian?

Minimize the need to be first on a new trend - this is just a poor risk/reward proposition. Let the others be guinea pigs, you can always enter a trend early after it is clear that is has been established. This is a much lower risk/higher reward proposition.

Never attempt to pick tops or bottoms - In a bear market, attempting to pick a bottom is known as "catching a falling knife." It usually ends in tears. As a bear trend becomes more mature and prices work their way lower the risk reward does indeed change, and hedging should be adjusted to reflect that fact. With the Dow at 11,000 I would be far more aggressive shorting that I would be with the Dow at 8,000. But I would still be short and not long in this bear market. I would be more careful and hedge differently as the bear market became more mature, but I would never go predominantly long until I was convinced the trend had changed. In short, trying to pick a bottom is a poor risk/reward proposition, to do so is to fight against the dominant trend, and fighting a dominant trend most often leads to failure. -John Bardacino